Medium- to long-duration bonds the sweet spot

Improvements in economic activity driven by external demand reduce likelihood of further easing


AT THE Monetary Policy Committee (MPC) meeting last Thursday, Bank Negara Malaysia (BNM) maintained the Overnight Policy Rate (OPR) at 1.75%, as widely expected by iFAST Research and all 20 economists surveyed by Bloomberg.

Improvements in economic activity driven by external demand reduce likelihood of further easing.

BNM has acknowledged continued improvements in economic activity year to date, driven by increased in public and private sector expenditure and stronger recovery in global demand which would benefit the manufacturing sector such as electronic and electrical products, primary-related subsectors and oil and gas sectors.

This is supported by the Purchasing Managers’ Index (PMI) which rose to 53.9 from 49.9 in March according to independent data provider IHS Markit.

The rise in PMI points to a robust improvement in the manufacturing sector on the back of increasing consumer confidence. The data registered in April underlines a growth output for the first time in nine months.

However, lockdowns amid a growing number of Covid-19 cases and slow vaccine rollout could dent the economic recovery.

The growing number of Covid-19 cases over the past month has led to a tightening of movement restrictions in selected areas such as Selangor and Kuala Lumpur.

The slower than expected vaccine rollout has added to growing concerns that there will be tighter movement restrictions in more areas. Should mobility be curtailed at an even higher rate, consumer spending is likely to soften while businesses are expected to remain cautious on capital expenditure. This, in turn, would put a dent in the 2021 growth reboundthatisexpectedtorangebetween 6% to 7.5%, according to various estimates.

The spike in consumer headline inflation of 1.7% in March — the highest rate since January 2018 — suggests inflationary pressure is present in the economy.

That being said, we believe it’s most likely temporary due to the low base effect from last year. Despite the increase in commodity prices of oil, steel, copper and lumber, to name a few, consumer demand conditions in the country remain soft and should keep consumer headline inflation numbers manageable in the upcoming months.

BNM has acknowledged in the Monetary Policy Statement the higher headline inflation is temporary and transitory due to cost-push factors such as global oil prices and low base effect rather than demand-pull factors and moderates subsequently.

This in turn should reduce the urgency of BNM to raise rates in the short run. Balancing the rising number of Covid-19 cases, the slower than expected vaccine rollout and a potential extensive movement restriction order on the cards against the strong manufacturing numbers and manageable inflationary pressure, we foresee BNM to remain accommodative in its monetary policy and maintain the OPR rate at the current rate of 1.75% at least until the third quarter of 2022.

We also expect BNM to make gradual rate hikes which are data-dependent so as to not hamper the economic recovery.

Bond investors should continue to stay invested: The sweet spot now is medium- to long-duration bonds.

In the second half of 2020, with yields and rates at historical lows, we advised investors to shorten the duration of their bond portfolio and look for value in the lower grade/ unrated bond segment.

Subsequently, as yields started to pick up back to the pre-pandemic levels in February to March 2021, we recommended increasing portfolio duration.

At this current juncture, we opine the sweet spot in Malaysia bonds is in the mediumto long-duration bonds. On one hand, investors can enjoy pre-pandemic level yields and spreads which are pretty decent, while only taking slightly higher duration risk which we also believe is rather limited as most of the hawkishness has been priced into the current yields already.

For the AAA and AA-rated segments, spreads have actually widened to above the five-year average spread, which could suggest that the segments are undervalued.

We still see attractiveness in the lower grade segment such as the A-rated segment or below, as the yield pick up of more than 200 basis points (bps) compared to AAA or AA-rated bonds and spread of 325bps over the risk-free rate are still very substantial.

In fact, this yield pickup and spread can help to cushion the portfolio amid any interest rate volatility, as what had happened in February and March this year.

The views expressed are of the research team and do not necessarily reflect the stand of the newspaper’s owners and editorial board.